SIFI Critics Ask: Are Broker-Dealers Next?

As U.S. and foreign regulators consider applying stricter regulations to non-bank firms deemed critical to the stability of the economy, industry groups are warning that such a move could saddle the mutual fund and insurance sectors with ill-conceived, burdensome regulations, and potentially spill over to other players like broker-dealers.

Those fears got an airing Wednesday at a Senate Banking Committee hearing, where industry officials and several lawmakers expressed concerns about the process by which the Financial Stability Board, an international regulatory consortium, and the U.S.-based Financial Stability Oversight Council are evaluating firms for designation as systemically important financial institutions, or SIFIs.

Paul Schott Stevens, president and CEO of the Investment Company Institute, a trade group representing asset managers, has been a vocal critic of the prospect of U.S. regulators tagging fund companies as SIFIs, a classification that would subject them to bank-like regulation by the Federal Reserve, and a similar review underway at the FSB.

At Wednesday's hearing, Stevens took aim at the international body, arguing that the FSB is turning a blind eye to crucial differences in how various segments of financial services approach issues like risk and liquidity.

"FSB asserts a very broad mandate -- no less than the stability of the entire global financial system, but most of its members, and virtually all of its leadership, consist of central bankers or finance ministry officials," Stevens says.

"The FSB describes its effort in the asset management sector as a review of, quote, 'shadow banking,'" he adds. "This disparaging term reflects the FSB's bias that all financial activity conducted outside of banks is inadequately regulated, and therefore is risky because it is not subject to bank standards and banks regulatory supervision."

'MORE POWER'

The FSB and FSOC are both creations of the response to the recent financial crisis, charged with reviewing market players to determine if adequate safeguards are in place to prevent a destabilizing run or if the collapse of a given firm could have a domino effect on the broader economy.

As legal entities, they are distinct. While an FSOC designation places a nonbank firm under the thumb of the Federal Reserve, the FSB does not have any legal standing in the United States. Still, some in industry fear that the FSOC is taking cues from the FSB, that a designation by the international body could merely be a precursor to prudential regulations imposed domestically.

Critics of the FSB's approach also caution that the group is casting too wide a net in its review of shadow banking, which could rope in broker-dealers, hedge funds, and "any other firm that is not a regulated bank," according to Peter Wallison, a fellow at the American Enterprise Institute, a conservative think tank.

"Regulators have an interest in having more power," Wallison says. "We have to recognize that regulation can be imposed because regulators want it to be imposed."

Those regulators counter that more risk and liquidity protections could be necessary to mitigate the damage that would occur from a mass sell-off or some other destabilizing event. Moreover, they maintain that the process of evaluating firms for designation as SIFIs is carefully considered, and that the Federal Reserve will "tailor, as appropriate, based on the specific business structures, activities, and other factors that may distinguish the designated companies from bank holding companies and foreign banking organization," the FSOC states on an FAQ page on its website.

Adam Posen, president of the Peterson Institute for International Economics, acknowledges that there are key distinctions between mutual funds and banks, but he does not buy the argument that asset managers are immune from destabilizing runs or that they should be exempt from enhanced regulation imposed by an entity like FSOC.

"It is correct and right for the ICI and others to go out there and say you cannot treat mutual funds and asset managers like banks," Posen says. "They're not the same as banks -- you have to judge the regulation appropriately, but it is not an argument that there should be no regulation or that we have sufficient regulation at this point."

TAILORED APPROACH

Still, critics like Stevens argue that the process of evaluating nonbank firms for SIFI designation is "almost reverse-engineered" to burden large mutual funds with prudential regulations that make little sense in an industry that doesn't rely on leverage and already has effective mechanisms to mitigate risk.

He notes that the International Organization of Securities Commissions recently said as much, calling for a more tailored approach that would consider mutual funds based on their distinct conduct. At the very least, Stevens contends, regulatory bodies mulling SIFI designations would do well to give capital-market authorities more of a voice in the process.

"IOSCO has said let's look at activities and products straight across the asset-management sector instead of, as the FSB's process essentially is doing, picking a handful of large U.S. mutual funds and U.S. advisors and recommending them for designation as SIFIs," Stevens says. "I think that the fundamental reform of the FSB is to reconstitute it in a significant way and break up the club of central bankers who have only one view of the world."